Interest rates are headed higher: What does this mean for the stock market?

In the first three months of 2017 in Canada the S&P/TSX Composite TR (Total Return) Index was up 2.4% while in the US the S&P500 TR Index in USD was up 6.1%. Although there has been a run-up in the markets over the last five months we remain very positive on the outlook for equities.

Since the election in November, the dominant force driving equity markets, not just in the US but around the world, has been the Trump presidency. The focus is on the expected pro growth policies of the President — lower corporate and individual tax rates, reforming the tax system, easing biting regulations, and spending $1 trillion on infrastructure — while not ignoring the noise of the distracting publicity he seems to seek. Although this economic upturn has been going on for a while the environment is still favourable for equities, and falling political uncertainty can only help.

In Canada, economic prospects have taken a notable upturn. Confidence barometers have strengthened across most parts of the country, and recent data show that increased optimism has been feeding through to a faster pace of spending and hiring. Infrastructure and fiscal stimulus measures should filter into the real economy during 2017 providing an extra boost. The cheaper loonie will likely benefit Canadian exports. Economic growth looks to be running at a 2% plus pace for each of the next two years.

The US economy is improving at a decent rate as well, growing by 1.6% in 2016. Official forecasts show 2% growth this year and next, as a result of sturdy job gains, rising wages, and rising household incomes. According to the president of the Federal Reserve Bank of New York, the household sector’s financial condition today is “in unusually good shape for this point in the economic cycle.”

Corporate profits too are expected to make steady advances over the next two years. Investment is now rising in the oil and gas sector, albeit off a diminishing base from the last couple of years.

More importantly, businesses are increasingly optimistic about the future. In fact “Executives are more upbeat about current economic conditions — both globally and in their home countries — than they were for all of 2016” according to McKinsey’s latest survey. In this environment, the stock market should continue to offer good returns.

Interest rates

John Williams, President of the Federal Reserve Bank of San Francisco: “Our aim is to keep the economic expansion on a sound footing that can be sustained for as long as possible. The last thing any of us want is to undermine the hard won gains we’ve made since the dark days of the recession … I’m often asked, since things are going well, why not just keep our foot on the gas? The answer is that lifting it gradually off the pedal prevents the economy from overheating. This is why the FOMC took action in March, and why the median view of my FOMC colleagues is for three interest rate increases in 2017.”

Central banks have maintained low interest rates to help spur economic growth over the past number of years. Now that we have firmer growth, interest rates are headed higher. Short term interest rates, now 0.75%, are headed towards 4%.

With most bonds offering negative real rates, we bias equities over bonds. Consequently our fixed income portfolios are very short term. They earn modest income but that is better than losing money in the ‘safe’ component of the portfolio.

Higher rates and the stock market

Higher interest rates are generally not a positive influence on the stock market. However, history shows that from a low base, as currently exists, the improving economy and the ensuing higher corporate profits more than counteracts the negative impact of the increasing rates.

The stock market has been rising, albeit below historic rates, for eight years, and is one of the longest rising markets in recorded history. Bull markets do not turn because of longevity. They usually turn because of excesses in the system, usually monetary. We are still quite a ways from that situation and as such we are still optimistic about the stock markets in North America.

In this backdrop our portfolios remain very strong. We built our firm by applying common sense to investing, by focusing on long term objectives rather than short term market outperformance, and by acting as an ‘owner’ rather than as a ‘renter’.

The main challenge for this strategy is how to apply it in all kinds of market environments. At Kingwest, we have been very disciplined and stayed true to our value process throughout the ups and downs of markets over the last 35 years.

Company profiles

FirstService Corporation is a company we have held in the portfolio for over a decade, earning outstanding returns throughout.

FirstService has two platforms. FirstService Residential is the largest manager of residential communities in North America, and FirstService Brands is a large provider of essential property services to residential and commercial customers in North America. Both platforms operate on the same foundation: managing and growing their market leading, value added property service businesses, in fragmented market segments. The company generates US$1.5 billion annually in revenues, with approximately 17,000 employees across North America and it is very profitable.

When we first bought the stock, the company enjoyed about 5% internal growth and because it generated substantial cash it would make small acquisitions in its core business to expand an additional 10% per year on average. These attributes are still true today and the business is executing that plan even more effectively than in the past. Notwithstanding the current rise in the share price, the market value still does not reflect the long term strengths of the company.

The Howard Hughes Corporation was formed in November 2010 as a tax free spinoff from General Growth Properties, a company we hold in the portfolio. Management has done an exceptional job of transforming the company’s disparate assets into a set of high quality assets. Yet, the share price has not received recognition for this tremendous value enhancement.

Howard Hughes develops and operates master planned communities and mixed use properties at the South Street Seaport in New York, Ward Village in Hawaii and master planned communities in Houston, Las Vegas and Maryland. These assets generate steady cash flow with substantial development opportunities that encompass more than 50 million square feet of development potential.

The company made meaningful progress in 2016. By the end of 2016 net operating income was running at an annual rate of $156 million, up from $118 million in 2015. And, this excludes income from the Seaport which is undergoing extensive redevelopment. When completed, net operating income should be about $225 million.

The value proposition is complicated by the vast development potential that cannot be estimated by simply applying a multiple to existing cash flows. We believe HHC is very undervalued and that further clarity around some of its bigger projects that we have highlighted will help drive the share price higher.

Going forward

To be a successful long term investor you must act like an owner, following common sense investing principles applied consistently through all kinds of markets. It is not to a rising market we look to earn our returns, but it is by purchasing outstanding, but undervalued, companies that increase in value due to fundamental improvements in the company’s affairs: that is what drives our results.

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Kingwest & Company is registered with the Securities Commissions in the provinces of Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario and Quebec in the categories of investment dealer and investment fund manager.